The financial landscape has undergone a profound transformation in the last decade.
Thanks to technological innovations, the rise of FinTech has made our daily life a lot more convenient with online shopping, mobile payments, buy-now-pay-later, and more.
In the summer of 2019, the concept of DeFi (Decentralized Finance) boomed in Web3. DeFi represents a fundamental shift in the way we think about and interact with financial systems.
Welcome to Module 7 - Course 1 of Mission Web3! In this course, we'll explore what DeFi is, its purpose in the web3 ecosystem, and how it enables a more decentralized and inclusive financial system.
What is DeFi?
DeFi, or Decentralized Finance, refers to the use of blockchain technology and cryptocurrencies to revolutionize traditional financial services like lending, borrowing, trading and more, in a decentralized and trustless manner.
In traditional finance, we delegate our trust to third parties such as banks and trading platforms to execute requests. Not only does it require a long period of time to process, especially on weekends and holidays, but humans errors and high transaction fees are unavoidable.
So how does DeFi solve these problems? The answer is smart contact. Smart contracts are self-executing contracts with the terms of the agreement directly written into code. They operate on blockchains like Ethereum, Binance Smart Chain, Base, and others. Smart contracts enable a wide range of financial services without the need for intermediaries, such as banks or brokers.
How it Works
In the DeFi space, lending platforms like Aave and Compound use smart contracts to facilitate lending and borrowing.
You can simply lock assets into a smart contract as collateral to borrow other assets, without going through the hideous process of finding a notary, revealing your bank statements and other financial documents. The smart contract will then automatically enforces the terms of the loan, including interest rates and collateral requirements. This process eliminates the need for a traditional bank or lending institution, making lending and borrowing more accessible and efficient.
Remember DEX (Decentralized Exchange) that we talked about In Module 4? DEXs like Uniswap also rely on smart contracts to enable peer-to-peer trading. You can swap one token for another directly from your wallet without an intermediary. Smart contracts will determine the exchange rate based on the token's supply and demand, and execute the trade securely.
There are more complicated use of smart contracts in DeFi:
Automated Market Makers (AMMs) create liquidity pools with smart contracts adjusting token prices dynamically based on the pool's reserve. Aerodrome Finance, for example, is a next-generation AMM designed to serve as the central liquidity hub for Base, combining a powerful liquidity incentive engine, vote-lock governance model, and friendly user experience.
Yield Farming and Liquidity Provision: DeFi platforms like Yearn.Finance and SushiSwap use smart contracts to automate complex strategies for yield farming and liquidity provision. Users can deposit their assets into smart contracts, which are then automatically allocated to various DeFi protocols to earn interest or rewards.
Prediction: Augur and Gnosis are examples of platforms that use smart contracts for prediction markets. You can create and participate in markets to bet on real-world outcomes. Smart contracts ensure that payouts are automatically distributed to the winning parties based on the market's outcome.
Unique Benefits of DeFi
A fundamental principle in DeFi is "code is law".
The rules and conditions embedded in smart contracts are transparent, immutable, and enforced by the blockchain. This means that once a smart contract is deployed, its rules cannot be altered or manipulated by any single entity. Users can trust the code to execute transactions as intended, removing the need for intermediaries and reducing errors and risks.
In addition, smart contracts are interoperable, interacting with one another to create a web of interconnected financial services. For example, your collateral in one DeFi protocol could be used as collateral in another, all facilitated by smart contracts. This interoperability enhances the potential for innovation and complex financial products within the DeFi ecosystem.